10-4. H-P executives indicate that they use traditional discounted cash flow (DC

Question

10-4. H-P executives indicate that they use traditional discounted cash flow (DCF) analysis to evaluate investment projects and that the firm’s cost of capital is about 12 percent. On October 15, 2003, H-P’s forward P/E ratio was 16.1, less than its historical value that stood around 20. H-P executives suggest that the lower P/E ratio reflected continued investor uncertainty about whether or not the merger would be successful. Discuss the manner in which H-P executives valued the expected cost savings stream when evaluating the merger. In particular address the following questions: Was the technique H-P executives used the same, or comparable, to traditional DCF analysis? Do you believe that H-P paid a reasonable premium for Compaq? Are there any valuation implications attached to H-P’s P/E ratio being at 16 rather than 20?

Explanation / Answer

Answer:-

The valuation technique used by HP executives was comparable to traditional DCF analysis. In valuing a company using traditional DCF analysis, one would first project the future cash flows generated and then discount the cash flow projections to obtain the present value by using the weighted average cost of capital as the discount rate. HP executives started off their valuation by projecting a combined net income of $4.2 billion and a perpetual after tax cost savings of $1.5 billion per year. The $1.5 billion annual cost saving was then capitalized using a P/E ratio of 20 (HP’s historic P/E) to arrive at a future value of $29.4 billion. The $29.4 billion future value was then discounted using a discount rate of 15% to arrive at the present value of net after-tax cost savings of $21.2billion.

HP’s valuation method was similar to traditional DCF in that HP took account of the time value of money and discounted the projected net after-tax cost savings using a15% discount rate. However, HP’s method was not fully in line with traditional DCF analysis because they only accounted for cost savings in their projection, and did not project or discount the future cash flows generated from the combined businesses. HP did not pay a reasonable price for Compaq, but grossly overpaid. This is likely due to HP executives being excessively optimistic in their valuation of the potential synergies resulting from the merger. They were also overly optimistic about the outcome of the merger and HP’s abilities to realize the full value of the synergies .Furthermore, by operating in the domain of loss, HP executives were substantially more risk seeking when evaluating the merger, agreeing to a merger with a not-so-profitable company in hopes of generating higher profits through the combined company. Together, these behavioural fallacies led HP to overpay for Compaq.

HP forward P/E of 16 reflecting investors’ uncertainties regarding the success of the merger has several valuation implication. in the eyes of H-P managers, it means that market judgement of the value of the synergies is only $17.3 billion rather than $21.2 billion. Of course, multiply by P/E is not the appropriate way to compute the fundamental value of cost saving.

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